Kiss the Tenants Goodbye

By

J.R. Brandstrader

Updated Sept. 18, 2006 12:01 a.m. ET

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THE FRANTIC CALLS ABOUT BROKEN TOILETS finally got to Chuck Parnes. He'd been able to retire at 60, thanks to prudent real-estate investments. But it seemed every time he tried to kick back and soak up the sun at his home in Studio City, Calif., there was another urgent message from a renter with a plumbing problem.

"I spent my Saturdays fixing a toilet or a sink," the 71-year-old recalls unfondly. Parnes, who'd wanted to travel with his wife, Judy, and visit their grandchildren after he quit his job as a traveling furniture salesman, couldn't do much of that until three years ago, when he joined a nascent wave of aging baby boomers who are kissing toilets, tenants and trash goodbye, in exchange for a monthly check from an ownership share of a bigger property.

Parnes made the switch as a "1031 exchange," so called for the number of the Tax Code section allowing tax-deferred swaps of "like kind" -- that is, investment -- real estate. Investors have used tax-deferred exchanges for decades to swap individual income properties, such as a $1 million rental condo in San Francisco for a $1 million townhouse in Boston. But under a recent twist, tax-deferred swaps investors like Parnes have been swapping the money they get when they sell small investment properties such as vacation homes and rental condos for stakes in much larger commercial real estate -- say, a Chicago office tower, Denver apartment building or Atlanta mall -- that can produce a steady stream of income.

The swap by Parnes was made under a concept known as tenant-in-common, an old form of ownership that has only recently gained traction in 1031 exchanges. TICs first became popular in 1031 exchanges on the West Coast; now, they've been embraced by investors across the country. Many, like Parnes, are tired of managing small properties on their own but yearn for income and are happy to delay the capital-gains tax they'd otherwise have to fork over on the sale of their rental real-estate.

The stock market's tame returns, when compared with real-estate gains over the past five or six years in many parts of the nation, also has boosted interest in TICs, says Dennis Helmick, president of the Federation of Exchange Accommodators. His organization comprises 305 qualified intermediaries, companies that play a key role in tax-deferred swaps. Most of the group's members "had record years last year and expect even more business this year," Helmick reports.

TICs didn't take flight in 1031 swaps until a 2002 Internal Revenue Service ruling clarified their tax status. "Knowing that a TIC satisfies the 1031 like-kind- exchange rules has increased not only the investors, but also the number of sponsors providing these investment vehicles," says Kyle Jeffers, a senior vice president for Countrywide Commercial Real Estate Finance in Calabasas, Calif.

A tenant-in-common sponsor buys a property, divides it into equal shares and sells them to investors through limited-liability corporations. Not every TIC involves the direct sale of real property. In fact, Los Angeles-based SCI Real Estate Investments, through which Parnes has acquired interests in Broadstone Heights, a gated apartment complex in Albuquerque, N.M., is one of the few large sponsors that do sell their investments as real property.

Most sponsors, however, sell ownership shares as securities under the Securities and Exchange Commission's Regulation D, which mandates full disclosure of all risks. Reg D requires that securities be sold only by licensed broker-dealers to "accredited investors" -- generally those whose net worth, individually, or jointly with a spouse, exceeds $1 million, or those who have had an individual annual income of more than $200,000, or a joint annual income over $300,000, for the two years before the deal is done.

The IRS mandates that a seller in a 1031 swap places the proceeds of the sale with a qualified intermediary, names the like-kind replacement property within 45 days of the sale and closes within a 180 days. Needless to say, professional help is available.

"We can help you identify and nominate a property within 45 days," says Ryan Bristol, CEO of PropPoint, in Santa Monica, Calif., one of many brokerage firms specializing in 1031 exchanges.

Of course, there are caveats. TIC investors lose control over their properties by putting their money in a potentially illiquid vehicle at considerable costs, warns Jim Shaw, chief executive of CapHarbor Real Estate Exchange Solutions, a Beverly Hills, Calif., brokerage that assists 1031 investors. There is no secondary market as yet for tenant-in-common shares, although in some deals there are mechanisms allowing a TIC sponsor to buy out an individual.

Typically, TICs are purchased through a limited-liability company, meaning the investors are at risk only for the amount of their stake. Since the properties are mortgaged, investors sign notes, but the loans on the investment are non-recourse, meaning the investor's other assets are protected if the sponsor defaults.

Transaction fees are another drawback: They can be hefty. In addition, there's an ongoing management fee -- typically 3% to 6% -- after the transaction is completed. But management is one of the things a TIC investor wants, and much of the original fees become part of the property's cost basis, reducing the capital-gains bite if the TIC investment ultimately is sold. And, of course, the deal puts off that day of reckoning as long as the investor retains his stake in the property.

Helmick advises investors to stick with sponsors who are members of the TIC Association, who, he says, conform to a code of ethics and a list of best practices.

A Heavy Load: Investors in tenants-in-common transactions buy stakes in industrial, office, retail, housing or other properties and gain considerable tax benefits... But the deals can carry one-time costs, shown above, that add 10% or so to a property's price, versus what a buyer would otherwise pay.

A thorough investigation of the investment is a must to avoid having a struggling property from being unloaded on an unsuspecting buyer who has seen real-estate prices only rise. For many investors, a visit to the property, regardless of how far away is worth the trip.

"You have to check vacancy rates, the economy, growth of household income [in the property's area], but you can find all of that stuff on the Internet," says Jeff Clark, an investor in Bend, Ore., who wanted to make sure he wasn't overpaying when he traded up to his first TIC with SCI a year and a half ago.

Clark, who says he's been buying and selling real estate since he was 17, had made a bundle investing in residential property. Through the TIC, he traded up to a commercial property -- Wal-Mart Way in Chesapeake, Va., a strip mall near the big retailer. He calls the step a matter of dollars and cents.

"Rents haven't gone up as much as housing prices," says Clark, who says he was getting only a 3% return on his properties after taxes and insurance, and that didn't include the value of the time it took to manage them.

After buying the TIC, "I was scared at first," he confesses, "and I had to take a leap of faith after doing a lot of research, and then I watched it really carefully, calling the property manager regularly to make sure I wasn't getting ripped off." He's now netting 7%, after fees.

SCI President and Co-chairman Marc Paul, whose company is one of the top three TIC sponsors, says that tenant-in-common arrangements are still only a minute part of the commercial-real-estate market.

"Of all the people who do 1031 exchanges, only about 12% chose TIC investing," he says.

"We project 2006 securitized TICs to reach $5 billion, up from $400 million in 2002," says CapHarbor's Jim Shaw. "If you include real-property TICs, it's roughly double. The number of TICs have roughly doubled every year since 2002."

For Parnes and Clark, it is so far, so good. "I have five or six [investments] with SCI, and it seems to be working," Parnes says. "I'm happy," says Clark. He hopes that he'll make a profit whenever he sells his interests. In the meantime, depreciation offsets most of the income he makes from the investment.

Observes Parnes, who says he's making 8&frac12;% on his TIC investments: "The whole key is letting go. That's the hard part. After being a hands-on person all these years, to let someone else run your property is hard to get used to. But as the checks keep rolling in, I'm getting more comfortable."

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